“Safe harbor” for financial contracts: The Fed’s final rule to enhance financial stability

On September 1, 2017, the Federal Reserve Board (Fed) finalized a new rule that should make it easier to wind down Global Systemically Important Banks (GSIBs), by creating a “safe harbor” for financial contracts after a bank defaults. The new rule will prevent derivatives contracts from being cancelled immediately when financial firms fail, with the intent of preventing any future calamity at one Wall Street institution from endangering the entire financial system.1 The rule requires GSIBs to amend the language in common financial contracts so that they cannot be immediately cancelled if the firm files for bankruptcy. These new legal protections imposed by the regulators aim to prevent any run on a GSIBs subsidiaries or counterparties, which could be triggered if large numbers of counterparties rush to terminate contracts, which occurred in the case of Lehman Brothers in 2008.2

What this Means

The Fed’s finalizing on September 1, 2017, of a rule that was first proposed in May 2016, is meant to formalize a strategy which has already been pursued by the financial industry.3 Major global banks agreed in 2014 to voluntarily make such changes to their contracts, inserting stays into the majority of these transactions. The Fed is now mandating that all GSIBs and the U.S. operations of foreign GSIBs amend their Qualified Financial Contracts (QFC) to prevent their immediate cancellation or termination if a firm enters bankruptcy or resolution.4

QFCs include derivatives, securities lending, and short-term funding transactions such as repurchase agreements. The Fed in a Press Release stated that given the large volume of QFCs to which GSIBs are a party, any mass termination in the event of a GSIB failure may lead to the disorderly failure of the firm, and in addition, to the transmission of financial distress across the U.S. financial system.5 The final rule contains two key requirements:6

The final rule requires QFCs of GSIBs, including those with foreign counterparties, to clarify if U.S. resolution laws that provide for a temporary stay to prevent mass terminations apply to the contracts.

The final rule prohibits the QFCs of GSIBs from allowing the exercise of default rights that could spread the bankruptcy of one GSIB entity to its solvent affiliates.

Fed Governor Jerome H. Powell stated that, “The final rule will reduce the threat that a disorderly unravelling of QFCs would pose to our financial system and the broader economy.”7

There are critics of the rule among hedge funds and insurance companies, who are often party to the other side of QFCs, and they have complained that banks were taking away protections from customers without giving them any say in the matter.8 In response to these comments, the Fed has tailored the transition period for compliance with the rule based on the type of counterparty. Equally, in recognition of the Trump Administration’s efforts to ease the regulatory burden, the final rule gives banks more time to comply, and reduces the number of QFCs covered by the rule.9

Conclusion

The final rule requires GSIBs to conform their QFCs with other GSIBs within one year, and within 18 months for QFCs with non GSIB financial counterparties. In addition, GSIBs will have two years to conform QFCs with community banks and all other counterparties.10 Fed Governor Powell said, “We looked for opportunities to reflect common sense changes to the proposed rule without sacrificing our goal to improve financial stability.”11 The Fed indicated that its rule will mean only a “modest” additional cost to the industry, with each termination delay being generally one business day, but in some cases up to 48 hours.12

U.S. regulators have been working to align domestic rules with an international agreement to mandate the stays, and the International Swaps and Derivatives Association (ISDA) has been working with regulators to help banks amend their contracts in line with the rule.13 Ann Battle, ISDA assistant general counsel said, “Today’s rulemaking is an important step toward ensuring the orderly resolution of U.S. GSIBs and thus protecting the U.S. financial system…We look forward to working with all market participants to develop a solution for compliance with the rule that both meets their needs and satisfies the Federal Reserve Board’s policy objectives.”14

These requirements will take effect in January 2019 for transactions between GSIBs, with contracts between large banks and other financial firms having to include stays by July 2019. The Fed has said that the Federal Deposit Insurance Corporation (FDIC) and the Office of Comptroller of the Currency (OCC) will likely follow up with similar rules.15

This blog is intended for general informational purposes only, does not take into account the reader’s specific circumstances, may not reflect the most current developments, and is not intended to provide advice on specific circumstances. Accenture disclaims, to the fullest extent permitted by applicable law, all liability for the accuracy and completeness of the information in this blog and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professional.

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